In Washington this week Prime Minister Kevin Rudd said, in reference to toxic assets polluting bank balance sheets: “This is the core of the global economic problem.” Actually the source of toxicity is the core problem and removing it is central to restoring confidence and providing a lasting fix.
The global banking system collapsed because it is opaque. Giant financial institutions fell into their own massive risk holes. Risk holes grow out of sight as capital was attracted to assets with upside risk but with an unseen hidden downside. Blind capital flows into risk holes, like a bath-tub vortex, drains the bath.
Risk transparency is the remedy. It avoids exposure to excessive unknown risk which means fewer and smaller surprises. Risk averse capital naturally flows away from transparent dangerous risk.
How is risk made transparent? Stress testing is the way to expose and measure risk holes. A stress test measures a bank’s balance sheet sensitivity to small and large changes in interest rates, exchange rates, property values and derivatives. It’s what VAR (Value at Risk), the global bank risk standard at the root of the crisis, does not do. Risk transparency simply means comprehensive price transparency — the most basic requirement of an efficient free market along with fair competition. Free market capitalism failed us because we never had it.
In February US Treasury Secretary, Timothy Geithner, unveiled the Obama administration’s bank stress testing program. This was a defining moment in the management of the global crisis. It demonstrated Geithner’s grip on the problem. Apparently stress testing is also in the Brown-Rudd plan. However, as yet, no administration has mentioned the obvious and potent way to stress test the global banking system — that is, a permanent bank risk website delivering transparent, continuous, integrated, automated bank stress testing. It’s the kernel of a new global regulatory institution — the International Risk Monitor (IRM).
World leaders, the IMF, G20, FSF and Basel Committee all call for tighter regulations to fix the causes of the current crisis. The single most important regulation missing in the world’s financial system is enforcement of the IRM. A virtual place where all banks in the world must report daily their exposure to wide-ranging movements in all the economic variables to which they are exposed. Non-bank counterparties to OTC derivatives should also report. A market in regulated transparent credit derivatives can feed into the IRM to rate counterparty risk adding a further layer of security. The IRM is just an online integration of data every bank should already have on hand. The IRM needs bold leadership, standards, protocols, modest resources and time. There is no reason to delay the start. The first step in this direction will ignite confidence in the banking system. Any hesitation in real transparency justifies the fear in the banking system.
The IRM has many payoffs. It will forever immunise the global banking system against excessive risk in the most effective way possible. The market will self-regulate risk continuously. Sound banks are protected as malicious rumours wither with nothing in doubt to feed them. The market can see and deal with risk holes as they form before the storm.
Some attractive add-ons go with global integration of risk. Market risks can be netted across regions and industry sectors, automatically, daily for all to see. Derivative risk nets to zero, this has very important audit implications in a global risk system. Any global deviation from zero in the IRM is unreported dark risk in the system — an immediate alert to the risk cops.
At last week’s G20 meeting of finance ministers in Sussex Treasurer Wayne Swan was greeted with the news that the UK Foreign Office had placed Australia in its low priority list. It’s a measure of G20 confidence in Australia’s economic creativity. Mr Swan has the perfect Australian black swan remedy in the IRM, calming many storms as Mr Rudd flies to the April 2 G20 leaders summit.
Australia can set an example to the world now. We are told our banks are healthy. Let’s see it. Capture the ground of a new global financial institution.
Ralph McKay has 20 years experience as a financial derivatives risk manager and is the author of “Risk Mechanics, Financial derivatives, finding and fixing risk holes.